time to get tax savvy, managing your tax burden

Time to Get Tax-SavvyManaging Your Tax Burden

Filling out and filing tax forms seems to become more complicated every year. There are more than 74,000 pages in the federal tax code, compared with about 40,000 in 1995 and 20,000 in 1974.

Source: CCH, 2014

Do You Dread Tax Season?

Before you take any specific action, be sure to consult with your tax professional.

Though it may seem daunting, the fact that there are so many rules, limits, and incentives built into the tax system also means there are plenty of legal ways to cut your tax bill. Becoming familiar with the basics and how to spot opportunities might help simplify the process and make it seem more routine.

Why We StressAbout 58% of all tax filers worry about completing and filing their tax returns. Here are some of their specific concerns.

26%Possibility of owing money

20%Not having the correct paperwork

19%An error could

prevent them fromgetting the

highest possible refund

18%A mistake

could trigger

an auditSource: National Endowment for Financial Education, 2013 (most current data available)

Taking Advantage of Tax Breaks

The formula for determining tax liability begins with your gross income, which includes just about everything you earn. Your adjusted gross income (AGI) excludes “above-the-line” adjustments such as pre-tax retirement plan contributions. Finally, any exemptions and deductions are subtracted from your AGI to arrive at your taxable income.

Retirement SavingsWhen you participate in an employer-sponsored

401(k) or 403(b) plan, you can allocate a percentage of your salary to your retirement account every pay period. Because contributions are made with pre-tax dollars, they are an effective way to reduce your taxable income.

The maximum annual contribution is $18,000 in 2016. If you will be 50 or older before the end of the tax year, you can contribute an additional $6,000. (Contribution limits are indexed annually for inflation.) The funds in your account will accumulate tax deferred until withdrawn, when they are taxed as ordinary income. Withdrawals prior to age 59½ may be subject to a 10% federal income tax penalty.

Some smart financial moves may help reduce your tax liability.

Taking Advantage of Tax Breaks A tax deduction is subtracted from taxable income.

A tax credit reduces your tax bill on a dollar-for-dollar basis.

Common Deductions and CreditsMost tax filers take the standard deduction, an amount set by the IRS each year. An individual or

couple can choose to forgo the standard deduction and instead claim itemized deductions. If you itemize, you may be able to deduct the following types of expenses from your adjusted gross income (up to certain limits) before income taxes are calculated.

Mortgage interest

Property, state, and local taxes

Student loan interest

Medical expenses

Charitable contributions

Some taxpayers may be eligible for education tax credits.

The American Opportunity Tax Credit offers a maximum annual credit of $2,500 for each of the first four years of a student’s post-secondary education.

The Lifetime Learning Credit is an annual nonrefundable credit of 20% of qualified tuition and fees up to $10,000 per year — so the maximum credit is $2,000. It applies to college undergraduate, graduate, and vocational education in an eligible educational institution.

Whether you are finalizing a yearly tax return or making key financial decisions, you might consider the difference between marginal and effective tax rates.

The United States has a progressive tax system, which means that tax rates increase as household income rises (see below). For example, if a couple files jointly and has a taxable income of $80,000 (after applicable deductions and exemptions) in 2016, they fall into the 25% tax bracket. However, they will not pay this rate on all their income, only on the amount over $75,300. In this case, 25% is their marginal tax rate or top tax rate.

Making Sense of Tax Rates

Source: Internal Revenue Service, 2015

2016 Tax Tables

Tax rate

10% Up to $9,275 Up to $18,550

15% $9,276 to $37,650 $18,551 to $75,300

25% $37,651 to $91,150 $75,301 to $151,900

28% $91,151 to $190,150 $151,901 to $231,450

33% $190,151 to $413,350 $231,451 to $413,350

35% $413,351 to $415,050 $413,351 to $466,950

39.6% Over $415,050 Over $466,950

Joint filersSingle filers

Income tax brackets and

income thresholds

What Happens at the EdgesPeople sometimes worry about being “pushed into a

higher tax bracket,” but only the amount of income that is in the next bracket is taxed at the higher rate. The rest of the income is taxed at rates in the lower bracket(s).

Looking at your taxes this way may make it easier to assess the true value of potential deductions and the taxability of additional income. For example, once you reach the 25% marginal tax threshold, you would owe $250 in taxes for each additional $1,000 of income up to the 28% threshold.

The Bigger PictureYour effective tax rate — the average rate at which your

income is taxed — offers a clearer view of the portion of

income that goes to Uncle Sam. To determine your effective

rate, divide your total taxes by your taxable income.

Returning to the previous example, a married couple

(filing jointly) with $80,000 in taxable income would have

an effective tax rate of about 14.4%.

First $18,550 at 10% rate $ 1,855.00

Next $56,750 at 15% rate + $ 8,512.50

Next $ 4,700 at 25% rate + $ 1,175.00

$11,542.50

$11,542.50 ÷ $80,000 = 14.4%

The alternative minimum tax (AMT) affects eight times as many taxpayers as it did 20 years ago. Many of these people do not consider themselves wealthy.

New Era for the AMT

The AMT Tales When the original law was passed in 1969, Congress

wanted to ensure that taxpayers with high incomes pay at least a minimum amount of taxes. However, lawmakers failed to index AMT exemption levels for inflation, so over time the tax grew to affect millions of taxpayers. For a number of years, lawmakers used temporary “patches” to help prevent more middle-income households from being hit, but the AMT’s reach continued to expand.

The American Taxpayer Relief Act of 2012 included a permanent AMT fix that indexed exemption levels annually for inflation, but it didn’t undo the damage entirely.

Two Ways to a Tax Bill The AMT is a parallel tax system that eliminates many

of the deductions, exemptions, and credits often used by taxpayers to reduce their tax bills under the normal rules. Consequently, more income may be taxable under the AMT. Taxpayers with incomes above the indexed exemption amounts ($53,900 for single filers and $83,800 for married joint filers in 2016) must calculate their taxes under both sets of rules and pay the higher of the two.

AMT rates range from 26% to 28%, compared with federal income tax rates that step up from 10% to 39.6%. However, the AMT doesn’t allow filers to claim personal exemptions, the standard deduction, or many other popular itemized deductions (including state, local, and property taxes).

Source: Tax Policy Center, 2015

Deductions

Who Takes the HitThe AMT was projected to raise roughly $27 billion from 4 million taxpayers in 2014.

Are You at Risk?The more exemptions and deductions that taxpayers normally claim,

the more vulnerable they may be to the AMT. If your gross income is above $100,000, you should complete IRS Form 6251 to see whether you owe the AMT. Any of the following circumstances could trigger AMT liability:

• A large number of personal exemptions, such as dependent children• Incentive stock options exercised during the year• Passive income or losses• Income from private-activity bonds• Significant itemized deductions, including state and local taxes (especially for residents of high-tax states), home-equity loan interest, unreimbursed employee expenses, and deductible medical expenses


Source: Tax Policy Center, 2015

Share of total AMT revenue

Under $100,000

$100,000 to $200,000

$200,000 to $500,000

$500,000 to $1 million

$1 million and above

40,000

472,000

699,000

123,000

2,650,000

<1%3%

43%

23%30%

Number of households owing AMT, by income level

Does not equal 100% due to rounding.

The personal exemption phaseout (PEP) and the Pease provision are rules that reduce the value of allowed deductions for high-income taxpayers.

Backdoor Taxes Return

PeaseHigher-earning taxpayers must reduce some valuable

itemized deductions (such as charitable donations and mortgage interest) by 3% of the amount that exceeds the $259,400 (single filer) and $311,300 (joint filer) thresholds. For example, a married couple with a $411,300 income who claim $50,000 in itemized deductions would have their allowed deductions reduced by $3,000 (3% of $100,000), which could increase their tax bill by about $1,000. A taxpayer’s itemized deductions cannot be reduced by more than 80% of the otherwise allowable amount.

PEP and Pease thresholds are adjusted annually for inflation.

PEP In 2016, single filers will lose 2% of their

personal exemptions for every $2,500 of adjusted gross income (AGI) over $259,400. The PEP threshold is $311,300 for married joint filers.

Backdoor Taxes Return Average Itemized Deductions

Based on preliminary data for tax year 2012. Includes only those returns claiming a deduction for that type of expense.

Source: CCH, 2015

Charitable contributions

$ 2,404

$ 2,990

$ 3,939

$ 5,667

$22,001

Interest

$ 7,047

$ 8,310

$10,399

$13,344

$18,786

Medical expenses

$ 6,939

$ 7,988

$ 9,634

$17,667

$33,521

Adjusted gross income

$30,000 to $50,000

$50,000 to $100,000

$100,000 to $200,000

$200,000 to $250,000

$250,000 or more

Taxes

$ 3,932

$ 6,201

$10,848

$17,556

$49,986

Your investing strategy is primarily influenced by such factors as your financial goals, time horizon, and risk tolerance. Even so, it might be wise to consider the tax implications of your investment decisions, especially when they involve assets that are not held in tax-advantaged retirement accounts.

Tax-Conscious Investing

The tax code treats long-term capital gains and qualified dividends more favorably than ordinary income (wages or interest from bonds and savings accounts). Generally, dividends on stocks that are held for at least 61 days within a specified 121-day period are considered “qualified” for tax purposes. Long-term capital gains are profits on investments held longer than 12 months. Nonqualified dividends and short-term capital gains are taxed as ordinary income.

High-income taxpayers may also be subject to a 3.8% net investment income tax on capital gains, dividends, interest, royalties, rents, and passive income if their modified adjusted gross income (AGI) exceeds $200,000 (single filers) or $250,000 (joint filers).

Realizing a large gain not only could trigger capital gain taxes but might push an investor’s adjusted gross income into a higher tax bracket or trigger PEP and Pease provisions that limit valuable personal exemptions and deductions.

Investment Tax Tally

Taxpayers who are thinking about selling appreciated investments could benefit by planning ahead and using certain strategies that may help minimize their overall tax burdens.

Timing asset sales to split gains over two or more tax years, or selling losing investments to offset gains, may help keep your income from crossing critical thresholds.

With property or business interests that are generally sold in a single transaction, it might be advantageous to arrange an installment sale in which the seller receives smaller payments over a period of years. Married couples who sell a principal residence (one they have lived in for at least two of the last five years) can typically exclude up to $500,000 in gains from their taxable incomes.

Consider making charitable donations with appreciated assets such as shares of stock instead of cash. Within certain limits, donors could avoid capital gain taxes and take a deduction that may help lower their taxable incomes.

*The 3.8% net investment income tax (also called the unearned income Medicare contribution tax) applies to the lesser of (a) net investment income or (b) the amount by which modified AGI exceeds the thresholds. The tax does not apply to municipal bond interest or IRA withdrawals.

Short-term capital gains on investments held 12 months or less are taxed as ordinary income, so investors in the top 39.6% tax bracket could owe up to 43.4% on short-term gains.

Source: Internal Revenue Service, 2015 (table shows 2016 AGI thresholds)

Married Single filer filing jointly

Married filing separately Head of household Tax rate

Long-term capital gain & dividend tax (taxable income thresholds)

Up to $37,650 Up to $75,300 Up to $37,650 Up to $50,400 0%

$37,651 up to $415,050 $75,301 up to $466,950 $37,651 up to $233,475 $50,401 up to $441,000 15%

More than $415,050 More than $466,950 More than $233,475 More than $441,000 20%

Net investment income tax (modified AGI thresholds)

Over $200,000 Over $250,000 Over $125,000 Over $200,000 3.8%*

For Better or WorseMany middle-income couples could receive a tax benefit from being married. When one spouse makes

significantly less money than the other or doesn’t have a job, their combined income — while taking advantage of deductions and exemptions for both spouses — may fall into a lower tax bracket, so the family may actually pay less in taxes overall.

Couples with similar incomes are more likely to encounter a penalty — generally once their combined taxable income rises above the 25% tax bracket — simply because the joint income thresholds of higher brackets are less than double the amounts for single filers.

Income taxes rarely play a major role in decisions about marriage, but most couples eventually consider how their official union affects their finances.

Will You Pay the “Marriage Penalty”?

Some married couples discover that they pay more in taxes than they would as unmarried individuals. This so-called marriage penalty has long been embedded in the structure of the U.S. tax code. In addition, tax increases that took effect in 2013 have the potential to hit married couples harder than single individuals, especially when both spouses earn high salaries (and/or have investment income).

It’s important for married taxpayers to arrange employer withholding to cover taxes based on their combined incomes; otherwise, they could end up paying out of pocket at tax time. In most cases, filing separately is unlikely to ease the situation.

Newlywed couples may find it helpful to estimate their taxes at least once before year-end, when there might still be time to make adjustments.

When a Child Should File a ReturnYou might assume that a young person doesn’t have to file a tax return until he or she has reached adulthood, moved out of the family home, and is generally self-supporting. Yet IRS rules regarding who must file are based on the amount and source of income rather than age.


Here are the general filing requirements affecting dependents—meaning

someone else pays more than half of their support

(including tuition, room, and board)— such as teens and

college students, as well as their parents.

Generally, a tax return must be filed if an individual has earned income above the standard deduction ($6,300 in 2016), unearned income from interest or dividends above $1,050, or a combination of earned and unearned income totaling more than $1,050 with at least $350 unearned. The filing threshold for net self-employment income is $400.

Unearned interest and dividend income (up to a maximum of $10,500) received by a dependent may be reported on a parent’s tax return. Otherwise, a separate return must be filed by the dependent or by a parent on the child’s behalf.Many young workers

who earn less than the filing threshold will want to file if they had income tax withheld from pay and are eligible for a tax refund.

The tax returns of about 1.2 million Americans were audited by the IRS in 2014, but nearly 1 million of these examinations were completed through correspondence.

Facing Audit Fears

The IRS probably won’t come knocking; it’s more common to find a letter from the tax collector in the mailbox. Receiving a notice from the IRS is not always as bad as it seems. It’s possible that the understaffed agency is trying to resolve a discrepancy between a line item noted on a return and what was reported by a third party. You may be asked to provide an explanation and/or specific documentation.

Unfortunately, jargon and legalese could make it difficult to understand exactly what the agency is requesting. Before you take any specific action, you might consult with your tax professional.


What factors increase the odds of an audit?

Audit Rates Rise with IncomesOverall, fewer than 1% of wage earners had their tax returns examined by the IRS in fiscal year 2014.

Income Percentage audited


Under $200,000 0.78%

$200,000 and higher 2.71%

$1 million and higher 7.50%

Large charitable deductions

Income level Unusually high expenses

Self-employment Omissions or mistakes

123

Source: Kiplinger.com, 2015

It normally takes about six to eight weeks for the IRS to issue a refund if you file a “complete and accurate” paper tax return, but it may take only three weeks if you file electronically. Either way, even minor mistakes could delay the processing of your return.

Here are a few of the most common errors the IRS finds on taxpayer forms.

Mistakes People Make

1 2 3 4Incorrect or missing

Social Security numbers

Misspelled last name (it must match

Social Security card)

Incorrect filing status for the taxpayer’s

situation

Math or computation errors (less common

when returns are filed electronically)


5 6Entering the wrong

bank account numbers for

direct deposit

Forgetting to sign and date the return —

both parties must sign joint returns

Time to Adjust Your Withholding?About 72% of taxpayers received refunds in 2015; the average refund was around $2,800. Taxpayers essentially loaned the government about $300 billion without earning any interest in return.

It feels good to get a refund, but it might make more sense for some people to increase their take-home pay. The extra money could be used to save more each month for retirement (which in some cases could trigger a larger employer match) or to pay down high-interest debt faster.

Many people prefer to withhold more so they will receive a large tax refund, believing they will spend the windfall more wisely than they would with a larger paycheck. Other taxpayers simply fill out their W-4 forms once and then fail to make adjustments as time passes.

You may want to reconsider your withholding decisions if you received a large refund or paid a tax bill last year, or if you’ve recently experienced a major life change such as marriage, divorce, a promotion, retirement, the birth of a child, or are paying for college.

The Internal Revenue Service has an online tool to help taxpayers determine their appropriate federal withholding (irs.gov). You may need to refer to your latest income tax return and pay stubs.


Add to savings

Americans’ Plans for Their Tax Refunds

47% 39% 25% 13% 11%

Source: National Retail Federation, 2015 (multiple responses allowed)

Add to savings Pay down debt Cover everyday expenses Take a vacation Make a major purchase

Funding an IRADid you know you can make IRA contributions for the previous year up to the April 15 tax filing deadline?* The maximum annual contribution to all IRAs combined is $5,500 ($6,500 for those 50 and older).

This hypothetical example is used for illustrative purposes only. The actual net savings in federal income taxes owed will vary.

Contribution Current-year tax savings by tax bracket

15% 25% 28% 33% 35% 39.6%

$5,500 $825 $1,375 $1,540 $1,815 $1,925 $2,178

$6,500 $975 $1,625 $1,820 $2,145 $2,275 $2,574

Incentive to SavePotential tax savings for maximum allowed traditional IRA contributions

Cut Taxes TodayContributions to a traditional IRA are generally tax deductible, but deductibility is limited for

higher-income workers who are active participants in an employer-sponsored retirement plan. In the 2015 and 2016 tax years, the phaseout ranges are $61,000 to $71,000 for single filers and $98,000 to $118,000 for joint filers.

Whether you owe taxes or expect a refund at tax time, the reduction in your tax liability could help fund your retirement contribution (see below). There may also be a reduction in your state income taxes. And don’t forget the potential for tax-deferred growth over the coming years.

*In 2016, the tax filing deadline is April 18 rather than April 15.

You must have earned income from wages to contribute to a Roth IRA or a traditional IRA. Once you reach age 70½, you can no longer contribute to a traditional IRA. Withdrawals from traditional IRAs are taxed as ordinary income. IRA withdrawals taken prior to age 59½ may be subject to a 10% federal income tax penalty, with certain exceptions such as those mentioned above.

Set Up Tax-Free Income for LaterA Roth IRA is funded with after-tax dollars, so there is no up-front tax

savings. However, Roth IRA owners can look forward to a time when their qualified distributions will be tax-free, regardless of how much growth the account experiences (under current tax law). A qualified distribution is one that meets the five-year holding requirement and takes place after age 59½ or results from the owner’s death or disability.

A Roth IRA can be a flexible way to save for retirement as well as other needs. Contributions (not earnings) can be withdrawn without penalty at any time, for any reason. There are also some convenient exceptions to the 10% penalty for early withdrawals of earnings. For example, a penalty-free IRA distribution could be used to purchase a first home ($10,000 lifetime maximum), to pay qualified higher-education expenses, or to pay unreimbursed medical expenses that exceed 10% of adjusted gross income (7.5% AGI for individuals aged 65 and older through 2016).

Eligibility to contribute to a Roth IRA phases out at higher modified AGI levels. In 2015: $116,000 to $131,000 for single filers and $183,000 to $193,000 for joint filers. In 2016: $117,000 to $132,000 for single filers and $184,000 to $194,000 for joint filers.

Preparing your tax return can be time-consuming, so it’s no wonder people often turn to professional tax preparers.

Still, you must make appropriate decisions throughout the year to avoid paying more taxes than necessary, especially

when the money might be put to better use, such as a home purchase, college savings, or your retirement nest egg.

Prepared by Emerald Connect, LLC, © 2016

time to get tax savvy, managing your tax burden

Economy & Finance